The Outlook for Bonds

10Y US Treasury Yield 2

Prominent warnings of soaring bond yields, and therefore losses for investors who own bonds, have been pervasive since the end of the global financial crisis in 2009. Perhaps the most famous such prediction came from Nassim Nicholas Taleb, who in 2010 said, “It’s a no brainer, every single human should short U.S. Treasury bonds.” But these prognostications have so far proved wrong, as bond yields have actually fallen. The yield on 10-year Treasury bond is below 2%, not far from its all-time low set in 2012. So when will bond yields actually start to rise and bond investors start to feel the pain?

The first thing to note is that there’s no immutable law of economics saying that bond yields have to rise back to what historically have been more “normal” levels. In Japan, which has suffered a quarter-century of weak economic growth, the yield on the government’s 10-year bonds has been below 2% almost constantly since the late 1990’s. It’s now close to 0%.

That being said, it’s still more likely than not that US bond yields will rise, especially given their current levels. A major determinant of longer-term bond yields is what investors expect short-term interest rates (which are set by the Federal Reserve) to be in the future. Amid signs over the past year that the US economy is strengthening, the Fed has signaled that it will likely start raising interest rates in the middle of this year.

But even that’s no guarantee that bonds will suffer. If the Fed raises interest rates too quickly and causes the economy to lose steam, bond yields could actually fall as investors anticipate that the Fed will have to halt or even reverse its rate rises. For bonds yields to rise substantially, economic growth has to remain strong enough that the Fed feels the need to continue to raise interest rates.

Given the headwinds facing the economy that are beyond the Fed’s control, such as an aging population and a weak global economy, it’s possible that the Fed won’t end up raising interest rates very quickly or very far. While bond yields are likely to rise from where they are currently, they won’t necessarily reach what many consider to be historically “normal” levels. The predictions of soaring bond yields could prove just as wrong in the future as they have for the past 6 years.

The Lesson of the Swiss Franc Surge

Swiss Franc

Last week Switzerland’s central bank shocked financial markets by removing the cap it had set on the value of the country’s currency, the Swiss franc. As a result the value of the franc surged more than 20% against the US dollar.

Switzerland comprises less than 4% of the global stock market, so for most American investors who aren’t currency speculators the surge didn’t directly have a large impact on their portfolios. But it was later revealed that a hedge fund, Everest Capital’s Global Fund, was essentially wiped out by the currency swing. And there were likely a number of other funds that were buffeted as well.

The travails of such funds highlight the importance of knowing what you own in your portfolio. “Knowing what you own” doesn’t mean memorizing the names of all your holdings or learning facts about each one. Instead it means having a high-level understanding of how the different pieces of your portfolio fit together: which asset classes, sectors, and regions of the world your portfolio is exposed to.

Having a clear understanding of these exposures can help ensure that your portfolio won’t be decimated when the price of some asset swings wildly, as occasionally happens. A sudden 20% movement for a currency as prominent in the global economy as the Swiss Franc is extremely rare. But with so many possible occurrences in financial markets, outcomes that individually seem like they should be rare actually happen fairly frequently. The price of a major commodity such as oil falling by 50% in a 6-month period is also a rare occurrence, for example, but such a plunge happened in the second half of 2014 (and an even larger one occurred only 6 years earlier, in 2008).

Trying to predict each one of these rare events would be a fool’s errand. Knowing what you own, and therefore being able to avoid any concentrated exposures that could ravage your portfolio, is a simpler and more rewarding alternative.

It’s Not Too Late for a 2014 IRA Contribution

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Taking advantage of tax-advantaged accounts, such as 401(k) and IRA accounts, can be one of the most effective tactics to get on track to reach your retirement goal. But if you forgot to make an IRA contribution for the 2014 tax year, it’s not too late. You actually have until tax day (April 15th) of this year to make an IRA contribution for 2014.

Like with most issues relating to taxes, the rules relating to IRA contributions aren’t exactly simple. But here are the basics:

– The yearly contribution limit into IRA accounts for anyone under the age of 50 is $5,500. For those 50 and over, the contribution limit is $6,500. Those are the limits for all your IRA accounts combined, so you can’t contribute $5,500 each to two different IRA accounts in the same year.

– For traditional IRA accounts (where your initial contribution is generally tax-deductible but you pay taxes when you withdraw the money in retirement), whether you can get the tax benefits from the IRA depend on whether you (or your spouse) are covered by a retirement plan at work as well as how high your income is.

– For Roth IRA accounts (where your initial contribution isn’t tax-deductible but you don’t pay taxes when you withdraw the money in retirement), whether you can contribute depends on your income. You can make a Roth IRA contribution up to the limit if your tax filing status is “single” and your income is less than $114,000, or if your tax filing status is “married filing jointly” and your income is less than $181,000.

You can find more details on the IRA contribution rules on the IRS website.

The Biggest Political Risks in 2015

Europe Vote

2014 was filled with political risk, a concept referring to political changes that can affect the value of an investment. From Russia’s military adventurism in Ukraine to renewed US military involvement in the Middle East, headlines were filled with geopolitical turmoil. But despite all the potential political conflicts, the ones that ended up metastasizing only minimally affected most investors. Even Russia comprises well below 1% of the global stock market. Political conflicts that could have more dramatically affected financial markets—such as China’s territorial disputes in the South China Sea and Scotland’s independence referendum—mostly fizzled out without causing too much financial damage. That could change in 2015 as political risk in Europe intensifies.

The surge of political risk in Europe has been caused by the rise of radical political parties that are less favorable toward European integration. Their support has been bolstered by the continent’s slow economic growth, a backlash against so-called “austerity” policies to reduce governments’ budget deficits, and disagreements between countries with struggling economies (such as Greece and Spain) and countries with stronger economies (such as Germany) over who should bear the cost of boosting economic growth.

There are a number of countries where these parties could potentially take power. Polls in Greece suggest that the radical Syriza party could win in the country’s parliamentary elections later this month. The party has pledged to fight for better terms for Greece from its international creditors, which has led to fears that a Syriza victory could lead Greece to exit the euro zone.

Radical anti-establishment parties in other countries could also achieve success in elections this year, such as the Podemos party in Spain, the Danish People’s Party in Denmark, and the UK Independence Party in the United Kingdom. Financial markets face additional uncertainty in the UK election, where Prime Minister David Cameron (from the mainstream Conservative Party) has pledged to hold a nation-wide vote on whether the UK (which is not part of the euro zone) should remain as a member of the European Union.

With so much electoral uncertainty in Europe, and even uncertainty about whether the euro zone and European Union will stay intact over the next few years, managing political risk will be a difficult. But that doesn’t mean investors should abandon international markets, or even abandon Europe. The lesson from 2014, when some countries viewed as politically risky (such as Russia) suffered cratering stock markets while others (such as China) performed well, is that being well-diversified internationally can be a good way to handle political risk.

2014 Recap: US Investments Shine While Commodities Lag

2014 was a year of divergence in the global economy: US economic growth accelerated, while growth in many other countries slowed or (especially in Europe) remained stagnant. Largely as a result of this trend, the US dollar increased in value against the world’s other major currencies. The implication for financial markets was a good year for US stocks and US bonds, a weak year for international stocks and international bonds, and a terrible year for commodities.

2014 Asset Classes

The top-performing sectors of the stock market were utilities, health care, communications, and consumer staples. These sectors are typically considered “defensive” sectors, meaning they often outperform the broader market when the economy is weak and underperform when the economy is strong. That fact may seem odd considering the signs—such as strong GDP growth and a declining unemployment rate—that the US economy is strengthening. But these are also sectors that tend to offer higher dividend yields, which make them particularly attractive to some investors in the current low-interest-rate environment. Since interest rates are likely to start rising in 2015, these sectors may not be able to continue their outperformance for much longer.

At the other end of the spectrum, energy was the only sector to post a negative return. Energy stocks suffered from the decline in commodity prices. Oil companies in particular were hurt as slowing economic growth in places such as China and increased production using methods such as hydraulic fracturing (or “fracking”) caused the oil price to halve in 2014.

2014 Stock Sectors

The top-performing countries were all Asian countries bouncing back from weak stock-market performances the previous year. The most notable of the group, India, saw a stock market surge as it recovered from an economic swoon in the middle of 2013 and as Narendra Modi’s Bharatiya Janata Party swept to power in elections in May.

The worst-performing countries were smitten with political turmoil. Russia’s military adventurism in Ukraine led to international sanctions, which combined with the plunging oil price devastated Russia’s energy companies and banks and caused the country’s currency, the ruble, to decline in value. In Greece, the rise of a radical anti-Europe Syriza party has led to speculation that the country could leave the euro zone in 2015.

2014 Countries

The ups and downs of financial markets in 2015 will likely be driven by a few key factors. Whether the global economy remains weak while the US economy surges ahead, and therefore whether the US dollar continues to gain value relative to other currencies, will affect the performance of essentially every asset class. How the Federal Reserve manages the US economy—can they begin to raise interest rates without slamming the brakes on economic growth?—will determine whether the winning streaks for US stocks and US bonds continue.

Whether the oil prices rebounds will affect not just commodities as an asset class, but also the energy sector and countries such as Russia that rely heavily on energy production. And political risk is likely to once again be an important factor in 2015, not just in small emerging markets but in Europe as well.